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Microeconomics: Review International Trade • Interdependence and trade allow everyone to enjoy a greater quantity and variety of goods & services. • Comparative advantage means being able to produce a good at a lower opportunity cost. Absolute advantage means being able to produce a good with fewer inputs. • When people – or countries – specialize in the goods in which they have a comparative advantage, the economic “pie” grows and trade can make everyone better off. A C T I V E L E A R N I N G 4: Absolute & comparative advantage Argentina and Brazil each have 10,000 hours of labour per month, and the following technologies: Argentina – producing one pound coffee requires 2 hours – producing one bottle wine requires 4 hours Brazil – producing one pound coffee requires 1 hour – producing one bottle wine requires 5 hours Which country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine? 3 A C T I V E L E A R N I N G 4: Answers Brazil has an absolute advantage in coffee: – Producing a pound of coffee requires only one labour-hour in Brazil, but two in Argentina. Argentina has a comparative advantage in wine: – Argentina’s opp. cost of wine is two pounds of coffee, because the four labour-hours required to produce a bottle of wine could instead produce two pounds of coffee. – Brazil’s opp. cost of wine is five pounds of coffee. 4 Markets and Competition • A market is a group of buyers and sellers of a particular good or service. • A competitive market is one in which there are so many buyers and so many sellers that each has a negligible impact on the market price. • A perfectly competitive market: – all goods are exactly the same – buyers & sellers so numerous that no one can affect the market price – each is a “price taker” • In this chapter, we assume markets are perfectly competitive. Demand Curve Shifters: Income • Demand for a normal good is positively related to income. – An increase in income causes increase in quantity demanded at each price, shifting the D curve to the right. (Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.) Summary: Variables That Affect Demand Variable A change in this variable… Price …causes a movement along the D curve No. of buyers …shifts the D curve Income …shifts the D curve Price of related goods …shifts the D curve Tastes …shifts the D curve Expectations …shifts the D curve Summary: Variables That Affect Supply Variable A change in this variable… Price …causes a movement along the S curve Input prices …shifts the S curve Technology …shifts the S curve No. of sellers …shifts the S curve Expectations …shifts the S curve A C T I V E L E A R N I N G 2: Supply curve Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide. 2: A. fall in price of tax return software ACTIVE LEARNING Price of tax return software S1 The S curve does not shift. Move down along the curve to a lower P and lower Q. P1 P2 Q2 Q1 Quantity of tax return software 2: B. fall in cost of producing the software ACTIVE LEARNING Price of tax return software S1 P1 S2 The S curve shifts to the right: at each price, Q increases. Q1 Q2 Quantity of tax return software 2: C. professional preparers raise their price ACTIVE LEARNING Price of tax return software S1 This shifts the demand curve for tax preparation software, not the supply curve. Quantity of tax return software Surplus: when quantity supplied is greater than quantity demanded P $6.00 D $5.00 $4.00 Surplus S Facing a surplus, sellers try to increase sales by cutting the price. This causes QD to rise and QS to fall… $3.00 …which reduces the surplus. $2.00 $1.00 $0.00 Q 0 5 10 15 20 25 30 35 Shortage: when quantity demanded is greater than quantity supplied P $6.00 S D $5.00 Facing a shortage, sellers raise the price, causing QD to fall and QS to rise, $4.00 …which reduces the shortage. $3.00 $2.00 $1.00 Shortage $0.00 Q 0 5 10 15 20 25 30 35 3: Changes in supply and demand ACTIVE LEARNING Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads. Event A: A fall in the price of compact discs Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Event C: Events A and B both occur. 3: A. fall in price of CDs ACTIVE LEARNING P The market for music downloads S1 STEPS 1. D curve shifts P1 2. D shifts left P2 3. P and Q both fall. D2 Q2 Q1 D1 Q ACTIVE LEARNING 3: B. fall in cost of royalties P The market for music downloads S1 STEPS 1. S curve shifts P1 2. S shifts right P2 S2 (royalties are part of sellers’ costs) 3. P falls, Q rises. D1 Q1 Q2 Q 3: C. fall in price of CDs AND fall in cost of royalties ACTIVE LEARNING STEPS 1. Both curves shift (see parts A & B). 2. D shifts left, S shifts right. 3. P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q. The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on: the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon: elasticity is higher in the long run than the short run. 3: Elasticity and changes in equilibrium ACTIVE LEARNING • The supply of beachfront property is inelastic. The supply of new cars is elastic. • Suppose population growth causes demand for both goods to double (at each price, Qd doubles). • For which product will P change the most? • For which product will Q change the most? 20 ACTIVE LEARNING 3: Answers When supply is inelastic, an increase in demand has a bigger impact on price than on quantity. Beachfront property (inelastic supply): P D1 D2 S B P2 P1 A Q 1 Q2 Q 21 ACTIVE LEARNING 3: Answers When supply is elastic, an increase in demand has a bigger impact on quantity than on price. New cars (elastic supply): P D1 D2 S P2 P1 B A Q1 Q2 Q 22 Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand In this case, buyers bear most of the burden of the tax. P Buyers’ share of tax burden PB S Tax Price if no tax Sellers’ share of tax burden PS D Q Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply P Buyers’ share of tax burden S PB Price if no tax Sellers’ share of tax burden In this case, sellers bear most of the burden of the tax. Tax PS D Q Other Elasticities • The income elasticity of demand measures the response of Qd to a change in consumer income. Income elasticity of = demand Percent change in Qd Percent change in income Recall from chap.4: An increase in income causes an increase in demand for a normal good. Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0. Other Elasticities • The cross-price elasticity of demand measures the response of demand for one good to changes in the price of another good. Cross-price elast. of demand = % change in Qd for good 1 % change in price of good 2 For substitutes, cross-price elasticity > 0 E.g., an increase in price of beef causes an increase in demand for chicken. For complements, cross-price elasticity < 0 E.g., an increase in price of computers causes decrease in demand for software. Evaluating the Market Equilibrium Market eq’m: P = $30 Q = 15,000 Total surplus = CS + PS Is the market eq’m efficient? P 60 S 50 40 CS 30 PS 20 10 D Q 0 0 5 10 15 20 25 30 ACTIVE LEARNING 1: Answers to B CS = ½ x $150 x 75 = $5,625 A $100 tax on airplane tickets P $ 400 350 300 PS = $5,625 PB = 250 tax revenue = $100 x 75 = $7,500 200 S PS = 150 D 100 total surplus = $18,750 DWL = $1,250 50 Q 0 0 25 50 75 100 125 28 Analysis of a Tariff on Cotton Shirts P free trade CS = A + B + C +D+E+F PS = G Total surplus = A + B +C+D+E+F+G tariff CS = A + B PS = C + G Revenue = E Total surplus = A + B +C+E+G Cotton shirts deadweight loss =D+F S A B $30 $20 C D E F G 25 40 70 80 D Q 2: Elasticity and DWL of a tax ACTIVE LEARNING Would the DWL of a tax be larger if the tax were on A. Rice Krispies or sunscreen? B. Hotel rooms in the short run or hotel rooms in the long run? C. Groceries or meals at fancy restaurants? 30 ACTIVE LEARNING 2: Answers A. Rice Krispies or sunscreen From Chapter 5: Rice Krispies has many more close substitutes than sunscreen, so demand for Rice Krispies is more price-elastic than demand for sunscreen. So, a tax on Rice Krispies would cause a larger DWL than a tax on sunscreen. 31 ACTIVE LEARNING 2: Answers B. Hotel rooms in the short run or long run From Chapter 5: The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run. 32 ACTIVE LEARNING 2: Answers C. Groceries or meals at fancy restaurants From Chapter 5: Groceries are more of a necessity and therefore less priceelastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries. 33 ACTIVE LEARNING 3: Discussion question • The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants. • Which should it tax? 34 DWL and the Size of the Tax Initially, the tax is T per unit. P new DWL Doubling the tax causes the DWL to more than double. S 2T T D initial DWL Q2 Q1 Q DWL and the Size of the Tax Initially, the tax is T per unit. P new DWL Tripling the tax causes the DWL to more than triple. S T 3T D initial DWL Q3 Q1 Q Revenue and the Size of the Tax P When the tax is small, increasing it causes tax revenue to rise. PB S PB 2T PS T D PS Q2 Q1 Q Revenue and the Size of the Tax P PB PB When the tax is larger, increasing it causes tax revenue to fall. S 3T 2T D PS PS Q3 Q2 Q Revenue and the Size of the Tax The Laffer curve shows the relationship between the size of the tax and tax revenue. Tax revenue The Laffer curve Tax size EXAMPLE 2: The Various Cost Curves Together $200 $175 $150 $125 Costs ATC AVC AFC MC $100 $75 $50 $25 $0 0 1 2 3 4 Q 5 6 7 ACTIVE LEARNING 3: Costs Fill in the blank spaces of this table. Q VC 0 1 10 2 30 TC AFC AVC ATC $50 n.a. n.a. n.a. $10 $60.00 80 3 16.67 4 100 5 150 6 210 150 20 12.50 36.67 8.33 $10 30 37.50 30 260 MC 35 43.33 60 41 ACTIVE LEARNING 3: Answers AFC = FC FC/Q Use First, relationship deduce ATC TC/Q = $50 and useMC FC +and VC =TC TC. between AVC VC/Q Q VC TC AFC AVC ATC 0 $0 $50 n.a. n.a. n.a. 1 10 60 $50.00 $10 $60.00 2 30 80 25.00 15 40.00 3 60 110 16.67 20 36.67 4 100 150 12.50 25 37.50 5 150 200 10.00 30 40.00 6 210 260 8.33 35 43.33 MC $10 20 30 40 50 60 42 The Revenue of a Competitive Firm • Total revenue (TR) • Average revenue (AR) TR = P x Q AR = • Marginal Revenue (MR): The change in TR from selling one more unit. MR = TR Q ∆TR ∆Q =P The Monopolist’s Profit Costs and Revenue As with a competitive firm, the monopolist’s profit equals MC P ATC ATC D (P – ATC) x Q MR Q © 2008 Nelson Education Ltd. Quantity